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CORPORATE FINANCE
Laurence Booth W. Sean Cleary Chapter 23 Working Capital Management: General Issues
Lecture Agenda
Learning Objectives Important Terms An integrated approach to working capital management Analyzing cash inflows and outflows Working capital management Summary and Conclusions
Concept Review Questions
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Learning Objectives
You should understand:
Why the management of net working capital is critical for the survival of the firm How managing receivables, inventory, and payables is related in an integrated approach to net working capital management How the financing and current asset investment decisions interact to determine a companys overall working capital position How some key financial ratios can be used to analyze a firms net working capital policies
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The way in which a firm manages both its current assets and its current liabilities.
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Management of the firms cash flow is one of the greatest challenges facing the financial manager:
Exhaustion of liquid resources can leave the firm unable to pay its maturing obligations as they come due (a state of technical insolvencyan Act of Bankruptcy)
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Continuing to produce inventory in the face of falling sales revenue. Selling products/services for less than their variable cost to produce.
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The monthly cash budget is a management tool used to forecast the timing, magnitude and duration of both cash surpluses as well as deficits.
Table 23-2 ABC's Six-Month Cash Budget
$
Sales Cash inflow Cash outflow Current sales Inventory Operating cash Start cash End cash Required cash Surplus/deficit
1
1,000 1,000 750 0 250 1,000 1,250 200 1,050
2
1,500 1,000 1,125 375 -500 1,250 750 300 450
3
2,000 1,500 1,500 375 -375 750 375 400 -25
4
2,500 2,000 1,875 375 -250 375 125 500 -375
5
3,000 2,500 2,250 375 -125 125 0 600 -600
6
3,500 3,000 2,625 375 0 0 0 700 -700
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The cash flow cycle where cash comes fromhow it is used to finance the operations of the firmand how it is recovered and how it grows over time is a crucially-important part of understanding how a business functions.
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Increasing long-term debt Increasing equity Increasing current liabilities Decreasing current assets other than cash Decreasing fixed assets
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Decreasing long-term debt Decreasing equity Decreasing current liabilities Increasing current assets other than cash Increasing fixed assets Paying dividends
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This Exercise
This exercise reinforces the classic working capital problem illustrated in the text. Demonstrates:
How cash is utilized over time in the firm. How investment in assets such as accounts receivable and inventory deplete cash resources. How the delays in receipt of cash from sales can leave a firm without cash, despite overall profitability.
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Step 1
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Step 2
Balance Sheet
$1m
Common Stock
$1 m
= $1,000,000
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Step 3
Fixed Assets
Balance Sheet Cash $0.5 F. Assets 0.5 Common Stock $1 m ___________________________________ T. Assets $1m T. Claims $1m
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Step 4
Fixed Assets
Cash Account
Inventory
Balance = $500,000
Balance Sheet
Cash $0.5 A/P $0.3 Inventory 0.3 F. Assets 0.5 Common Stock $1 m _____________________________________ T. Assets $1.3m T. Claims $1.3m
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Value is added to inventory through labour ($300,000) and equipment ($100,000). Further
Step 5
Fixed Assets
Labour/utilities
Cash Account
Inventory
Balance = $500,000
Balance Sheet Cash $0.5 A/P $0.3 Inventory 0.7 Accruals 0.3 F. Assets 0.4 Common Stock $1 m _____________________________________ T. Assets $1.6m T. Claims $1.6m
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Suppliers of initial inventory are paid ($0.3m). Labour costs ($0.2m in accruals) are paid resulting in a $0 cash balance.
Step 6
Work-in-process inventory
Fixed Assets
Labour/utilities
Balance = $0
$300,000 paid
Balance Sheet
Cash $0.0 A/P $0.0 Inventory 0.7 Accruals 0.1 F. Assets 0.4 Common Stock $1 m _____________________________________ T. Assets $1.0m T. Claims $1.1m
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Sale of inventory occurs. Accounts receivable created. Cash = $0. There are 30 days till A/R collected.
Step 7
Work-in-process inventory
Fixed Assets
Labour/utilities
Cash Account
Inventory
Balance = $0
Balance Sheet Cash A/R Inventory F. Assets $0.0 0.5 0.3 0.4 A/P $0.0
Accruals 0.1 Common Stock $1 m R/E 0.1 ____________________________________ T. Assets $1.2m T. Claims $1.2m
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1
1,000 1,000
2
1,500 1,000
3
2,000 1,500
4
2,500 2,000
5
3,000 2,500
6
3,500 3,000
7
4,000 3,500
8
4,500 4,000
9
5,000 4,500
10
5,500 5,000
11
6,000 5,500
12
6,500 6,000
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The cash budget is a planning tool used to forecast cash inflows and outflows (usually each month) out into the future. The purpose of the cash budget is to forecast the timing, magnitude and duration of cash flow surpluses and deficits. The cumulative impact of the cash inflows/outflows will be forecast through the cash budget.
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$ Cash
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$ Cash
How much the firm is likely to need to borrow to cover a projected deficit.
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$ Cash
The length of time that the projected cash deficit will last is useful in choosing the right financing solution, but is also an important control mechanism for monitoring after the fact.
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Cash Budgets
Dealing with Forecast Surpluses Knowing the timing, magnitude and duration of cash surpluses allows management to choose the most appropriate management response:
Small Amount of Surplus available for a short period of time (ie. less than $100,000)
Keep in current account
Large Sum available for a short period of time 30 90 days (ie. greater than $100,00)
Invest in money market securities such as T-bills
Cash Budgets
Dealing with Forecast Deficits Knowing the timing, magnitude and duration of cash deficits allows management to choose the most appropriate management response:
Small deficit persisting for a short period of time (ie. less than $100,000)
Delay purchases, speed collections and try to synchronize cash flows to eliminate or minimize, or Negotiate an operating line of credit with the financial institution
Large deficit forecast to last a short period of time 30 90 days (ie. greater than $100,00)
Operating line of credit, or Seek longer term permanent capital solutions if large cash flow deficits are likely to reoccur.
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[ 23-1]
Cash St 1[1-b(1 2 g )]
Where:
g = monthly sales growth b = the cash production cost and (1 b ) = unit contribution margin, and St-1 = Sales at time minus 1
We can create a formula to explore the sensitivity of the firms cash position with respect to the firms credit, inventory and payables policies. Let:
= the firms credit policy as the percentage of sales collected this month 1 = the balance of sales collected in the month following sales = the proportion of this months production costs paid in this month 1 - = the proportion of production costs paid next month. = perecentage of the firms monthly sales tied up in inventory
CHAPTER 23 Working Capital Management General Issues 23 - 37
[ 23-2]
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[ 23-3]
We can now graph the change in cash against the sales growth rate:
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Cash Sb-1
(1-b)
( b( ))g
g
Break-even Sales Growth Rate
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Cash Sb-1
(1-b)
( b( ))g
g
Break-even Sales Growth Rate
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Cash Sb-1
(1-b)
( b( ))g
g
Break-even Sales Growth Rate
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[ 23-4]
1 b g [b( ) ]
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[ 23-5]
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Quick ratio
Excessive liquidity will reduce ROI and ROE. It can also mean the firm is too lenient in terms of credit policy, or may have excessive inventories that may be subject to technological obsolescence.
CHAPTER 23 Working Capital Management General Issues 23 - 46
Receivables turnover(R T)
[ 23-7]
[ 23-8]
The shorter the collection period, the lower the cash sensitivity to changes in sales.
CHAPTER 23 Working Capital Management General Issues 23 - 47
[ 23-9]
InventoryTurnover(I T)
[ 23-10]
InventoryTurnover(I T)
Sales Inventory
The higher the inventory turnover, the lower the sensitivity of cash to changes in sales.
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[ 23-10]
InventoryTurnover(I T)
[ 23-11]
The higher IT the lower ADSI showing more efficient inventory management and a reduced sensitivity of cash to changes in sales.
CHAPTER 23 Working Capital Management General Issues 23 - 49
[ 23-12]
[ 23-13]
PT shows how many times a year a firm pays off its suppliers on average. ADSP shows how long a firm defers payments to its suppliers.
CHAPTER 23 Working Capital Management General Issues 23 - 50
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[ 23-14]
OC ADSI ACP
Operating cycle is a function of average days sales in inventory and the average collection period.
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[ 23-15]
CCC OC - ADSP
The estimated time between when a firm pays cash for inventory purchases and when it receives cash from sales.
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Management of the cash cycle can make an important difference in the amount of financing required, assets employed to generate a given level of sales...and therefore, can affect ROA and ROE.
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Inventory sold Inventory purchased Inventory period Accounts payable period Cash paid for inventory Accounts receivable period
Cash received
Time
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What is the difference between profit and cash flow from operations?
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Internet Links
Treasury Management Association of Canada Canadian Tire Air Canada Dominion Bond Rating Service Standard and Poors
Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.
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Short-term Borrowing
Short-term Credit
short-term loans can be secured much more quickly than long-term credit short-term credit is generally more flexible
low flotation costs generally no prepayment penalties fewer restrictive covenants
with an upward sloping yield curve - short-term credit is normally less expensive than long-term debt short-term credit may be more risky than long-term debt:
interest rate risk exposure renegotiation risk
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costs:
Effective ratesimple = interest/amount received = $800/$10,000 = 8%
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Effective ratediscount = interest/amount received = interest/(Face value - interest) = $800/($10,000 - $800) = 8.7% or Effective ratediscount = 8%/(1-.08) = 8%/(.92) = 8.7%
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Commercial Paper
short-term unsecured promissory note issued only by the most credit-worthy of corporate issuers by-passes banks and allows the firm direct access to the money market is a negotiable security that does not carry a stated rate of interest, rather, it trades at a discount from par value.
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Bankers Acceptances
an alternative to commercial paper for smaller firms that dont have the credit-worthiness to secure commercial paper financing. a money market instrument the bank accepts the promissory note by stamping it accepted....the note therefore is secured by the Banks promise to pay.
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Pledging of A/R
lender has claims against the receivables as well as recourse to the borrower. the risk of default on the receivable stays with the borrower. the buyer of the goods does not know that the receivables have been pledged as collateral for a loan.
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Inventory Financing
Blanket Liens - gives the lending institution a lien against all of the borrowers inventories. Trust Receipts - issued for specific items of inventory. The lending institution sends someone to the borrowers premises to periodically check that the numbers are correctly listed. Warehouse Receipts - either an independent third party warehouses the goods, or the goods are secured in a separate location on the borrowers property. Warehouse financing involves:
physical control of the inventory supervision by a custodian
- used to finance the seasonal buildup of inventory. - ensures proper warehousing practices...and inventory control. - because of the foregoing, inventory becomes more acceptable as collateral.
public notification
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120 100 80 60 40 20 0 Ja Fe Ma Ap Ma Jn Ju Au Se Oc No De
CHAPTER 23 Working Capital Management General Issues 23 - 79
Cash Inventories
the firms financial position firms will look most healthy if the fiscal year end is set sometime after the seasonal sales peak....long enough afterward to see receivables collected. auditors preferences auditors are busy around the calendar year end...with firms and individuals that have selected Dec 31 as their year end. auditors are busy from February through May with income tax
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Key Topics
Reasons for holding Cash Advantages of holding Cash Cash Budgets Cash Management Techniques Marketable Securities Management Criteria for selecting marketable securities Balancing Cash and Marketable Security Holdings
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Marketable Securities
holding M/S
conservative working capital management strategy finance seasonal/cyclical needs build funds for a major investment/acquisition/cash outflow productive precautionary balance
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